Tuesday, June 18, 2013

IMF points to major risks in Portugal's path to recovey

As the IMF approved its latest tranche of bailout funds for Portugal last week, the organization pointed out significant risks to the nation's economy and its deficit reduction targets.

The IMF (report attached): - The solid social and
political consensus that to date has buttressed strong program implementation has weakened
significantly. Economic recovery is also proving elusive. And with the program bereft of tools to
boost competitiveness in the near-term, there is a high risk that adjustment will continue to take
place through more demand compression with too little compensating expenditure switching
due to higher exports—particularly in light of still difficult euro area economic environment.

For a while it looked as though Portugal could potentially export its way out of the mess it was in. But those hopes have been dashed recently, as the nation's net trade balance growth has stalled. What happened? Slow global demand softened growth in exports. At the same time, domestic demand, stung by austerity measures, keeps declining at 6-8% annually.

Source: Barclays Capital

With the risk of a sharper slowdown elevated, the IMF focused on four stress tests that were applied to Portugal's debt to GDP projection: growth shock, rate spike, decline in potential (as opposed to actual) GDP growth, and contingent liabilities. Here they are.

The IMF: -

1. A growth shock that lowers the output by
cumulative 5 percentage points in 2013 – 15
would raise the debt peak by 7 points to 131½
percent of GDP.

2. An interest rate spike of 400 bps on all debt in
2013 – 15 would not have a large immediate
effect, but it would slow down the rate of debt
decline in the medium term, so that by 2020
the debt-to-GDP ratio is 5 points higher
compared with the baseline.

3. A reduction in potential growth (from two to
one percent in real terms) will have an impact
that is numerically similar to the impact of an
interest rate spike noted above.

4. Realization of contingent liabilities (15 percent
of GDP...) would
immediately push debt close to 140 percent of
GDP; debt would fall below 120 percent of GDP
only in 2023 [this includes the 9 percent of GDP in debt of the SOEs that are classified outside the general government - see post on the topic]

And here is what the results look like. The combination of these factors looks particularly ominous with government debt to GDP growing to 150%.

Source: IMF

The risk of Portugal running into at least some of these headwinds - which would result in potentially higher/longer bailout requirements - remains elevated. The IMF has already loosened some fiscal consolidation targets for Portugal, but given the uncertainties involved, many economists remain skeptical.

WSJ: - The fund Wednesday approved a loosening of the country's deficit-reduction targets, giving Lisbon more time to tighten the country's budget.

Portugal's economy is struggling with imposed austerity—including tax increases, wage cuts and cuts in the health and education sectors—and healthy growth is nowhere in sight. Output is expected to shrink 2.3% this year after a 3.2% contraction in 2012, while unemployment is close to 18%.

The fund said it can't say with high probability that Portugal's debt is sustainable over the long term, and noted the country's finances are vulnerable to potential distress such as a deteriorating growth outlook and higher borrowing rates.